Wall Street Expects a Miracle. You Shouldn’t

By Jack Hough

U.S. corporate earnings are up about 8% during the second-quarter reporting season. But don’t worry: Wall Street analysts predict the growth rate will quicken again soon, reaching a handsome 13% next year.

On second thought, worry. A turnaround like that would require, if not quite a biblical miracle, at least an economic one.

Three reasons: First, U.S. economic growth has recently slowed — to 1.5% during the second quarter, according to the earliest of three estimates from the Commerce Department, from 2% in the first quarter and 4.1% in the fourth quarter of 2011. Emerging markets are growing faster than America and Europe, but rates are declining around the world.

Corporate profits depend on many factors, and chief among them is the broad pace of economic growth. But another is the share of economic activity captured by corporations as profits, versus the one captured by workers as income.

That’s the second reason Wall Street’s forecasts look too glib: Corporations are taking a record share of economic activity, and workers, a slim share. In the past, such imbalances have always reversed. It’s not clear whether that pattern will repeat now. But even if it doesn’t, companies can’t be expected to outgrow the economy from here like they have in recent years.

Lastly, even the second quarter’s 8% earnings growth rate is plumper than it should be, due to a lucky contribution from Bank of America. It reported a modest profit during the second quarter versus a giant loss a year earlier on accounting charges.

The bank’s large stock market value gives it outsized influence on S&P 500 results. Without its contribution, earnings would have grown 3%, according to Gregory Harrison, an analyst at Thomson Reuters.

A better gauge of growth for investors is the rate at which revenues are increasing: 0.8% during the second quarter. Without a pick-up in the economy, earnings growth might look similarly feeble in coming quarters.

That’s no reason for panic, but it’s reason for investors to become less brave.

Some stock buyers are lately paying any price for the handful of companies that are still growing healthily (see “Time to Sell Amazon Stock”). Others are paying dearly for “defensive” companies, or ones whose earnings tend to hold up when the economy slows.

But paying a high price for anything now means betting on expectations. Better to put low expectations to work by favoring strong companies whose earnings may dip during a slowdown, but whose shares can now be had for a song (see “For Bargain Stocks, Look to ‘Risky’ Ones”).

Raise a bit of cash, too. The S&P 500 has returned 13% so far this year, much more than it typically returns in a full year. It trades at 14 times trailing earnings, on par with its historical average — but growth looks likely to slip below average for a while.

The latest inflation rate, this year through May, is 1.7%. It will be difficult to top that with short-term safe money, but if the economy remains weak, price growth may slow further. (It has been zero or negative for each of the past three months.)

Savers can find six-month bank certificates of deposit that pay 0.8% and one-year ones that pay 1.1%, according to BankRate.com. By the time those come due, the market may be coming to terms with the fizzling earnings boom, and stock buyers may find some better deals.

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